Contributed by Lee Jason Goldberg
In Part I of this entry, we examined developing jurisprudence in Second Circuit courts regarding the safe harbor in section 546(e) of the Bankruptcy Code by discussing Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.). In Quebecor, the Second Circuit held that transfers in connection with a securities contract made by or to (or for the benefit of) a financial institution/intermediary (terms which the court used interchangeably) may qualify for the section 546(e) safe harbor even if the financial institution/intermediary is merely a conduit.
In Parts II and III of this entry, we explore two issues: first, whether a “financial intermediary” is required for the safe harbor to apply, and second, whether undoing a transaction must pose a risk to the financial markets for the transaction to receive the protection of the section 546(e) safe harbor. Although the Second Circuit has suggested its views on these issues, its decisions arguably are not clear, and we need more guidance. For the second issue, guidance is particularly necessary in the context of small transactions.
In Quebecor, the Second Circuit shielded a transfer of approximately $376 million from avoidance. Subsequently, two New York bankruptcy courts shielded, under section 546(e), transfers from avoidance that were a mere fraction of the amount of the transfer in Quebecor: the Western District of New York bankruptcy court in Cyganowski v. Lapides (In re Batavia Nursing Home, LLC, et al.) and the Northern District of New York bankruptcy court in Woodard v. PSEG Energy Technologies Asset Mgmt. Co., LLC, et al. (In re Tougher Industries, Inc., et al.). (After Batavia and Tougher were decided, the Supreme Court denied the petition for writ for certiorari filed by Quebecor USA’s creditors’ committee.)
We explore the two issues above through these cases, but before doing so, we examine the role of Congressional intent in the interpretation of the section 546(e) safe harbor.
A Question of Congressional Intent?
Prior to the Second Circuit’s decisions in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.) and Quebecor, the Southern District of New York bankruptcy court in Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.) refused to interpret section 546(e) to apply to a small private stock sale (representing transfers totaling just over $1.1 million) made through “financial institutions,” notwithstanding the “apparent” plain meaning of the statute.
Despite expressing trepidation about “line drawing based on presumed Congressional intent,” the MacMenamin’s court found that it was “quite easy to find that the transaction at issue here would have absolutely no impact on the financial markets.” The court acknowledged, however, that it was somewhat difficult to articulate a clear standard to distinguish the transaction before it from the facts of QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), (a “large private LBO transaction . . . with a $208 million purchase price and hundreds of selling shareholders, where at least some of the sales went through a financial intermediary that was arguably involved in the securities markets”), where the Sixth Circuit held that the section 546(e) safe harbor applied, or “any number of hypothetical transactions in between.”
In the case before it, though, the MacMenamin’s court found that the defendants had not “provided any evidence that the avoidance of the transactions at issue involved any entity in its capacity as a participant in any securities market, or that the avoidance of the transactions at issue poses any danger to the functioning of any securities market.” The court viewed its conclusion as required by the Congressional intent behind the section 546(e) safe harbor.
Enron and Quebecor
As we noted in Part I of this entry, after MacMenamin’s was decided, the Enron court explained that Congress enacted section 546(e) to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries. The Second Circuit noted that if a firm were required to repay amounts received in settled securities transactions, it could have insufficient capital or liquidity to meet its current securities trading obligations, placing other market participants and the securities markets themselves at risk. The Quebecor court later quoted this language and found that a “transaction involving one of these financial intermediaries, even as a conduit, necessarily touches upon these at-risk markets.”
Courts in the Second Circuit, including the Second Circuit itself in Enron, frequently reference the purpose of section 546(e), including the “risks” to, and “stability” of, the “financial markets” and the “securities markets,” even though no such language appears in the statute. At the same time, they purport to rely on the plain language or meaning of section 546(e) in applying the safe harbor. Thus, in Enron, the Second Circuit, despite its discussion of the purpose of the statute earlier in its decision, stated that it reached its conclusion by looking to the statute’s plain language and declined to address Enron’s arguments regarding legislative history, “which, in any event, would not lead to a different result.” In Quebecor, the Second Circuit similarly purported to reach its conclusion based on the “plain language” of the statute but still discussed the statutory purpose to bolster its conclusion.
But, what if a party’s arguments regarding legislative history did lead to a different result, such as in MacMenamin’s? In refusing to protect a transaction from avoidance under the section 546(e) safe harbor despite the statute’s “apparent” plain meaning, the court in MacMenamin’s found that the statute’s legislative history “makes it clear that Congress intended section 546(e) to address risks that the movants have failed to show conclusively are implicated by the avoidance of the transaction at issue here.” In light of Enron and Quebecor, may a Second Circuit court likewise refuse to apply the section 546(e) safe harbor if a party claiming its protection cannot show that undoing a transaction would pose a risk to the financial markets?
After the Second Circuit’s decision in Enron (but prior to its decision in Quebecor), the District Court for the Southern District of New York in AP Services LLP v. Silva held that the section 546(e) safe harbor extended to a leveraged buyout in which five shareholders received $106 million – transferred by wire directly into their bank accounts – in exchange for their privately held stock. Among other things, the court in Silva made two key holdings regarding application of the section 546(e) safe harbor. First, the court held that a “financial intermediary” was not required, only a “financial institution” (defined in section 101(22) of the Bankruptcy Code), such as the defendants’ banks. Second, the court refused to require a factual determination as to whether upsetting a concluded LBO would have an adverse effect on the financial markets.
This entry explores the Silva holdings, on which the courts in Batavia and Tougher relied for their analyses, in the context of small transactions.while,
Two Small LBO Cases
In Batavia, the chapter 11 trustee sought to avoid a $1.179 million transfer made to one of the debtors’ former owners to buy out his interests in the debtors and several other entities. The debtors had issued bonds to fund the buyout and for other financing needs. Bank of New York Mellon, the indenture trustee for the bonds, wired $1.179 million of the bonds’ proceeds to the bank account of the former owner’s law firm to buy out his interests.
In Tougher, the chapter 11 trustee sought to avoid transfers totaling approximately $3.6 million made to the debtor’s former shareholder to buy out all of the debtor’s stock. The relevant transfers were wired from the debtor’s bank account directly to the shareholder’s bank account, with the majority of such payments funded through the debtor’s bank loans.
The buyouts in Batavia and Tougher were, therefore, very similar, except for their funding: the Batavia LBO was funded by the issuance of bonds, and the Tougher LBO was funded primarily by bank loans. In the remainder of this entry, we examine the application of the first Silva holding in the Tougher case, while in Part III, we will examine how the Batavia and Tougher courts relied on the second Silva holding to analyze the much smaller LBOs at issue in their cases.
Is a “Financial Intermediary” Required for Application of the Safe Harbor?
In Tougher, the court rejected the trustee’s argument that the section 546(e) safe harbor was inapplicable because the settlement payments did not pass from the debtor through a financial intermediary to the defendant. The court relied on Silva’s holding that “nothing in the language of the statute or the post-Enron case law indicates that an intermediary is necessary to trigger the safe harbor.” According to the court in Tougher, “[i]n addressing the legislative purpose of § 546(e), the [Silva] court found the reasoning of Enron applicable and stated that the negative effects of undoing long-settled LBOs would be ‘equally true regardless of whether a payment passed through a financial intermediary.’”
Although the Silva and Tougher courts applied the Second Circuit’s reasoning about undoing long-settled LBOs to payments made to “financial institutions” rather than only payments passed through “financial intermediaries,” neither court elaborated on how the negative effects would be equally true in both situations. Nonetheless, if the Second Circuit is confronted with the question of whether a “financial institution” or a “financial intermediary” is required for the protection of the section 546(e) safe harbor, it may reach the same conclusion as that reached by the courts in Silva and Tougher – that only a “financial institution” is required. Even though the Second Circuit may reach this conclusion notwithstanding certain distinguishing factors in Enron and Quebecor, it is at least worth considering those distinguishing factors.
First, in each of Enron and Quebecor, the transaction involved a traditional “financial intermediary,” the Depository Trust Company in Enron and CIBC Mellon (the noteholders’ trustee) in Quebecor. The issue was whether the section 546(e) safe harbor applied to a transaction even if a financial intermediary did not have a beneficial interest in the transfer or was merely a conduit. This is different from the lack of a traditional financial intermediary altogether in Silva and Tougher, where only banks (“financial institutions”) participated in the transactions.
Second, in Enron, the Second Circuit was rejecting the argument that the absence of a financial intermediary taking a beneficial interest in the securities during the course of the transaction failed to implicate the systemic risks that motivated Congress’s enactment of the section 546(e) safe harbor. The Second Circuit cited reasoning from the Third Circuit (Brandt v. B.A. Capital Co. LP (In re Plassein Int’l Corp.)), the Sixth Circuit (QSI), and the Eighth Circuit (Contemporary Indus. Corp. v. Frost), that “undoing long-settled leveraged buyouts would have a substantial impact on the stability of the financial markets, even though only private securities were involved and no financial intermediary took a beneficial interest in the exchanged securities during the course of the transaction.”
According to the Second Circuit, there was “no reason to think that undoing Enron’s redemption payments, which involved over a billion dollars and approximately two hundred noteholders, would not also have a substantial and similarly negative effect on the financial markets.” Furthermore, as we noted in Part I, the Quebecor court observed that financial intermediaries are typically facilitators of, rather than participants with a beneficial interest in, the underlying transfers, and that “[a] clear safe harbor for transactions made through these financial intermediaries promotes stability in their respective markets and ensures that otherwise avoidable transfers are made out in the open, reducing the risk that they were made to defraud creditors.” (Actual fraudulent transfers under section 548(a)(1)(A) are excluded from the section 546(e) safe harbor.)
Thus, the context in which the Quebecor and Enron cases arose – transactions representing hundreds of millions and over one billion dollars, respectively, conducted through traditional financial intermediaries – may have informed the Second Circuit’s analysis of the section 546(e) safe harbor. This analysis does not foreclose the result reached in Silva and Tougher, though.
The Silva and Tougher courts relied on the Third Circuit’s decision in Plassein, which the Enron court cited with approval. Plassein involved LBO payments made not through financial intermediaries but directly to shareholders’ private bank accounts via wire transfer. In that case, the Third Circuit rejected the argument that settlement payments must travel through the settlement system (i.e., the system of intermediaries and guarantees usually employed in securities transactions) and found that “financial institutions” were implicated in the transfers: the debtor’s bank transferred the buyout funds to the shareholders’ banks.
Moreover, the Silva and Tougher courts correctly pointed out that “financial institution” is the term actually used in the statute, with the Tougher court observing that the plain language of section 546(e) does not contain a requirement that a financial intermediary act as a conduit or take a beneficial interest in the transfer. The court in Tougher further remarked that if Congress had intended that the safe harbor only be applied to transactions involving financial intermediaries, it would have explicitly included that language in the statute.
Although the Second Circuit’s repeated references to the purpose of section 546(e) may leave room to argue that the safe harbor should only apply to transactions involving financial intermediaries, the Second Circuit may find it dispositive that the plain language of the statute (i.e., “financial institution”) does not require a financial intermediary for application of the safe harbor.
For Safe Harbor Protection, Must Undoing a Transaction Pose a Risk to the Financial Markets?
In our next entry, we explore, through the Batavia and Tougher cases, whether a party must show that undoing a transaction would pose a risk to the financial markets for the transaction to receive the protection of the section 546(e) safe harbor.
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